A coal power plant in Germany. Due to emissions trading, coal may become less competitive as a fuel.

A central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emission allowance must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society.[1]

The overall goal of an emissions trading plan is to reduce emissions. The cap is usually lowered over time - aiming towards a national emissions reduction target.[4] In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap and trade systems, organizations which do not pollute may also participate, thus environmental groups can purchase and retire allowances or credits and hence drive up the price of the remainder according to the law of demand.[5] Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction.

Because emissions trading uses markets to determine how to deal with the problem of pollution, it is often touted as an example of effective free market environmentalism. While the cap is usually set by a political process, individual companies are free to choose how or if they will reduce their emissions. In theory, firms will choose the least-costly way to comply with the pollution regulation, creating incentives that reduce the cost of achieving a pollution reduction goal.

The efficacy of, what later was to be called, the "cap and trade" approach to air pollution abatement was first demonstrated in a series of micro-economic computer simulation studies between 1967 and 1970 for the National Air Pollution Control Administration (predecessor to the United States Environmental Protection Agency's Office of Air and Radiation) by Ellison Burton and William Sanjour. These studies used mathematical models of several cities and their emission sources in order to compare the cost and effectiveness of various control strategies.[6][7][8][9][10] For each abatement strategy comparison was made with the "least cost solution" produced by a computer optimization program which finds the least costly combination of source reductions to achieve a given abatement goal.[11] In each case it was found that the least cost solution was dramatically less costly than the same amount of pollution reduction produced by any conventional abatement strategy.[12] This led to the concept of "cap and trade" as a means of achieving the "least cost solution" for a given level of abatement.

The development of emissions trading over the course of its history can be divided into four phases:[13]

Gestation: Theoretical articulation of the instrument (by Coase, Dales, Montgomery etc) and, independent of the former, tinkering with "flexible regulation" at the US Environmental Protection Agency

Proof of Principle: First developments towards trading of emission certificates based on the "offset-mechanism" taken up in Clean Air Act in 1977.

Prototype: Launching of a first "cap and trade" system as part of US Acid Rain Program, officially announced as a paradigm shift in environmental policy, as prepared by "Project 88", a network building effort to bring together environmental and industrial interests in the US

Regime formation: branching out from US clean air policy to global climate policy, and from there to the European Union, along with the expectation of an emerging global carbon market and the formation of the "carbon industry".

The textbook emissions trading program can be called a "cap and trade" approach in which an aggregate cap on all sources is established and these sources are then allowed to trade amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline and credit program.[14] In a baseline and credit program a set of polluters that are not under an aggregate cap can create credits by reducing their emissions below a baseline level of emissions. These credits can be purchased by polluters that do have a regulatory limit. Many of the criticisms of trading in general are targeted at baseline and credit programs rather than cap type programs.

It is possible for a country to reduce emissions using a Command-Control approach, such as regulation, direct and indirect taxes. The cost of that approach differs between countries because the Marginal Abatement Cost (MAC) — the cost of eliminating an additional unit of pollution — differs by country. It might cost China $2 to eliminate a ton of CO2, but it would probably cost Sweden or the U.S. much more. International emissions-trading markets were created precisely to exploit differing MACs.

Emissions trading can benefit both the buyer and the seller through 'Gains from Trade'.

Consider two European countries, namely Germany and Sweden. Each can either reduce all the required amount of emissions by itself or it can choose to buy or sell in the market.

Example MACs for two different countries

For this example let us assume that Germany can abate its CO2 at a much cheaper cost than Sweden, e.g. MACS > MACG where the MAC curve of Sweden is steeper (higher slope) than that of Germany, and RReq is the total amount of emissions that need to be reduced by a country.

On the left side of the graph is the MAC curve for Germany. RReq is the amount of required reductions for Germany, but at RReq the MACG curve has not intersected the market allowance price of CO2 (market allowance price = P = λ). Thus, given the market price of CO2 allowances, Germany has potential to profit if it abates more emissions than required.

On the right side is the MAC curve for Sweden. RReq is the amount of required reductions for Sweden, but the MACS curve already intersects the market price of CO2 allowances before RReq has been reached. Thus, given the market allowance price of CO2, Sweden has potential to profit if it abates fewer emissions than required internally, and instead abates them elsewhere.

In this example Sweden would abate emissions until its MACS intersects with P (at R*), but this would only reduce a fraction of Sweden’s total required abatement. After that it could buy emissions credits from Germany for the price 'P' (per unit). The internal cost of Sweden’s own abatement, combined with the credits it buys in the market from Germany, adds up to the total required reductions (RReq) for Sweden. Thus Sweden can also profit from buying credits in the market (Δ d-e-f). This represents the ‘Gains from Trade’, the amount of additional expense that Sweden would otherwise have to spend if it abated all of its required emissions by itself without trading.

Germany made a profit by abating more emissions than required: it met the regulations by abating all of the emissions that was required of it (RReq). Additionally, Germany sold its surplus to Sweden as credits, and was paid 'P' for every unit it abated, while spending less than 'P'. Its total revenue is the area of the graph (RReq 1 2 R*), its total abatement cost is area (RReq 3 2 R*), and so its net benefit from selling emission credits is the area (Δ 1-2-3) i.e. Gains from Trade

The two R* (on both graphs) represent the efficient allocations that arise from trading.

If the total cost for reducing a particular amount of emissions in the 'Command Control' scenario is called 'X', then to reduce the same amount of combined pollution in Sweden and Germany, the total abatement cost would be less in the 'Emissions Trading' scenario i.e. (X - Δ 123 - Δ def).

The example above applies not just at the national level: it applies just as well between two companies in different countries, or between two subsidiaries within the same company.

The nature of the pollutant plays a very important role when policy-makers decide which framework should be used to control pollution.

CO2 acts globally, thus its impact on the environment is generally similar wherever in the globe it is released. So the location of the originator of the emissions does not really matter from an environmental standpoint.

The policy framework should be different for regional pollutants[15] (e.g. SO2 and NOX, and also mercury) because the impact exerted by these pollutants may not be the same in all locations. The same amount of a regional pollutant can exert a very high impact in some locations and a low impact in other locations, so it does actually matter where the pollutant is released. This is known as the 'Hot Spot' problem.

A Lagrange framework is commonly used to determine the least cost of achieving an objective, in this case the total reduction in emissions required in a year. In some cases it is possible to use the Lagrange optimization framework to determine the required reductions for each country (based on their MAC) so that the total cost of reduction is minimized. In such a scenario, the Lagrange multiplier represents the market allowance price (P) of a pollutant, such as the current market allowance price of emissions in Europe[16] and the USA.[17]

All countries face the market allowance price as existent in the market that day, so they are able to make individual decisions that would maximize their profit while at the same time achieving regulatory compliance. This is also another version of the Equi-Marginal Principle, commonly used in economics to choose the most economically efficient decision.

There has been longstanding debate on the relative merits of price versus quantity instruments to achieve emission reductions.[18]

An emission cap and permit trading system is a quantity instrument because it fixes the overall emission level (quantity) and allows the price to vary. One problem with the cap and trade system is the uncertainty of the cost of compliance as the price of a permit is not known in advance and will vary over time according to market conditions.

In contrast, an emission tax is a price instrument because it fixes the price while the emission level is allowed to vary according to economic activity. A major drawback of an emission tax is that the environmental outcome (e.g. a limit on the amount of emissions) is not guaranteed.

The best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damages avoided by a reduction) when the level of emission control is varied.

Because there is high uncertainty in the compliance costs of firms, some argue that the optimum choice is the price mechanism.

However, some scientists have warned of a threshold in atmospheric concentrations of carbon dioxide beyond which a run-away warming effect could take place, with a large possibility of causing irreversible damages. If this is a conceivable risk then a quantity instrument could be a better choice because the quantity of emissions may be capped with a higher degree of certainty. However, this may not be true if this risk exists but cannot be attached to a known level of GHG concentration or a known emission pathway.[19]

A third option, known as a safety valve, is a hybrid of the price and quantity instruments. The system is essentially an emission cap and tradeable permit system but the maximum (or minimum) permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or purchasing them from the government at a specified trigger price (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by giving governments the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough, or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism.[20]

All three methods are being used as policy instruments to control greenhouse gas emissions: the EU-ETS is a quantity system using the cap and trading system to meet targets set by National Allocation Plans, the UK's Climate Change Levy is a price system using a direct carbon tax, while China uses the CO2 market price for funding of its Clean Development Mechanism projects, but imposes a safety valve of a minimum price per tonne of CO2.

The Kyoto Protocol is a 1997 international treaty which came into force in 2005, which binds most developed nations to a cap and trade system for the six major හරිතාගාර වායු.[21] (The United States is the only industrialized nation under Annex I which has not ratified and therefore is not bound by it.) Emission quotas were agreed by each participating country, with the intention of reducing their overall emissions by 5.2% of their 1990 levels by the end of 2012. Under the treaty, for the 5-year compliance period from 2008 until 2012,[22] nations that emit less than their quota will be able to sell emissions credits to nations that exceed their quota.

It is also possible for developed countries within the trading scheme to sponsor carbon projects that provide a reduction in greenhouse gas emissions in other countries, as a way of generating tradeable carbon credits. The Protocol allows this through Clean Development Mechanism (CDM) and Joint Implementation (JI) projects, in order to provide flexible mechanisms to aid regulated entities in meeting their compliance with their caps. The UNFCCC validates all CDM projects to ensure they create genuine additional savings and that there is no carbon leakage.

The Intergovernmental Panel on Climate Change has projected that the financial effect of compliance through trading within the Kyoto commitment period will be 'limited' at between 0.1-1.1% of GDP among trading countries.[23] By comparison the Stern report placed the costs of doing nothing at five to 20 times higher.[24]

In 2003 the New South Wales (NSW) state government unilaterally established the NSW Greenhouse Gas Abatement Scheme to reduce emissions by requiring electricity generators and large consumers to purchase NSW Greenhouse Abatement Certificates (NGACs). This has prompted the rollout of free energy-efficient compact fluorescent lightbulbs and other energy-efficiency measures, funded by the credits. This scheme has been criticised by the Centre for Energy and Environmental Markets of the UNSW (CEEM) because of its reliance upon offsets. [25]

On 4 June 2007, former Prime Minister John Howard announced an Australian Carbon Trading Scheme to be introduced by 2012, but opposition parties called the plan "too little, too late."[26] On 24 November 2007 Howard's coalition government lost a general election and was succeeded by the Labor Party, with Kevin Rudd taking over as prime minister. Prime Minister Rudd announced that a cap-and-trade emissions trading scheme would be introduced in 2010.[27]

Australia's Commonwealth, State and Territory Governments commissioned the Garnaut Climate Change Review, a study by Professor Ross Garnaut on the mechanism of a potential emissions trading scheme. Its interim report was released on 21 February 2008.[28] It recommended an emissions trading scheme that includes transportation but not agriculture, and that emissions permits should be sold competitively and not allocated free to carbon polluters. It recognised that energy prices will increase and that low income families will need to be compensated. It recommended more support for research into low emissions technologies and a new body to oversee such research. It also recognised the need for transition assistance for coal mining areas. [29]

In response to Garnaut's draft report, the RuddLabor government issued a Green Paper[30] on 16 July that described the intended design of the actual trading scheme. Draft legislation will be released in December 2008, to become law in 2009.[31]

The European Union Emission Trading Scheme (or EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world and was created in conjunction with the Kyoto Protocol.

After voluntary trials in the UK and Denmark, Phase I commenced operation in January 2005 with all 15 (now 25 of the 27) member states of the යුරෝපියානු සංගමය participating.[32] The program caps the amount of carbon dioxide that can be emitted from large installations, such as power plants and carbon intensive factories and covers almost half of the EU's Carbon Dioxide emissions.[33] Phase I permits participants to trade amongst themselves and in validated credits from the developing world through Kyoto's Clean Development Mechanism.

Whilst the first phase (2005 - 2007) has received much criticism due to oversupply of allowances and the distribution method of allowances (via grandfathering rather than auctioning), Phase II links the ETS to other countries participating in the Kyoto trading system. The European Commission has been tough on Member States' Plans for Phase II, dismissing many of them as being too loose again.[34] In addition, the first phase has established a strong carbon market. Compliance was high in 2006, increasing confidence in the scheme, although the value of allowances dropped when the national caps were met.

All EU member states have ratified the Kyoto Protocol, and so the second phase of the EU ETS has been designed to support the Kyoto mechanisms and compliance period. Thus any organisation trading through the ETS should also meet the international trading obligations under Kyoto.

The නවසීලන්තය Government introduced a bill for emissions trading schemes before a select committee. Various reports by a range of groups support the scheme but differ in opinion as to how it should be implemented.[35] An interesting feature of the New Zealand Emissions Trading Scheme is that it includes forest carbon and creates deforestation liabilities for landowners.[36]

The emissions trading bill passed into law on 10 September 2008. On November 16 2008 the newly formed National-led government announced that it would delay implementation of the ETS pending a full review of climate change policy.

සැකිල්ල:Related An early example of an emission trading system has been the SO2 trading system under the framework of the Acid Rain Program of the 1990 Clean Air Act in the U.S. Under the program, which is essentially a cap-and-trade emissions trading system, SO2 emissions were reduced by 50 percent from 1980 levels by 2007.[37] Some experts argue that the "cap and trade" system of SO2 emissions reduction has reduced the cost of controlling acid rain by as much as 80 percent versus source-by-source reduction.[38][39]

In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System.[40] Beginning in 2000, over 100 major sources of pollution in eight Illinois counties began trading pollution credits.

In 2003, New York State proposed and attained commitments from nine Northeast states to form a cap and trade carbon dioxide emissions program for power generators, called the Regional Greenhouse Gas Initiative (RGGI). This program is due to launch on January 1, 2009 with the aim to reduce the carbon "budget" of each state's electricity generation sector to 10 percent below their 2009 allowances by 2018.[41]

Also in 2003, U.S. corporations were able to trade CO2 emission allowances on the Chicago Climate Exchange under a voluntary scheme. In August 2007, the Exchange announced a mechanism to create emission offsets for projects within the United States that cleanly destroy ozone-depleting substances.[42]

In 2007, the California Legislature passed the California Global Warming Solutions Act, AB-32, which was signed into law by Governor Arnold Schwarzenegger. Thus far, flexible mechanisms in the form of project based offsets have been suggested for five main project types. A carbon project would create offsets by showing that it has reduced carbon dioxide and equivalent gases. The project types include: manure management, forestry, building energy, SF6, and landfill gas capture. California is also one of seven states and three Canadian province that have joined together to create the Western Climate Initiative, which has recommended the creation of a regional greenhouse gas control and offset trading environment.[43]

On November 17, 2008 President-elect Barack Obama clarified, in a talk recorded for YouTube, that the US will enter a cap and trade system to limit Global Warming.[44]

The 2010 United States federal budget proposes to support clean energy development with a 10-year investment of US $15 billion per year, generated from the sale of greenhouse gas (GHG) emissions credits. Under the proposed cap-and-trade program, all GHG emissions credits would be auctioned off, generating an estimated $78.7 billion in additional revenue in FY 2012, steadily increasing to $83 billion by FY 2019.[45]

Renewable Energy Certificates, or "green tags", are transferable rights for renewable energy within some American states. A renewable energy provider gets issued one green tag for each 1,000 KWh of energy it produces. The energy is sold into the electrical grid, and the certificates can be sold on the open market for additional profit. They are purchased by firms or individuals in order to identify a portion of their energy with renewable sources and are voluntary.

They are typically used like an offsetting scheme or to show corporate responsibility, although their issuance is unregulated, with no national registry to ensure there is no double-counting. However, it is one way that an organization could purchase its energy from a local provider who uses fossil fuels, but back it with a certificate that supports a specific wind or hydro power project.

Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO2e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO2e)[46] which was itself a 41% increase relative to 2003 (78 mtCO2e).[47]

In terms of dollars, the World Bank has estimated that the size of the carbon market was 11 billion USD in 2005, 30 billion USD in 2006,[46] and 64 billion in 2007.[48]

The Marrakesh Accords of the Kyoto protocol defined the international trading mechanisms and registries needed to support trading between countries, with allowance trading now occurring between European countries and Asian countries. However, while the USA as a nation did not ratify the Protocol, many of its states are now developing cap-and-trade systems and are looking at ways to link their emissions trading systems together, nationally and internationally, to seek out the lowest costs and improve liquidity of the market.[49] However, these states also wish to preserve their individual integrity and unique features. For example, in contrast to the other Kyoto-compliant systems, some states propose other types of greenhouse gas sources, different measurement methods, setting a maximum on the price of allowances, or restricting access to CDM projects. Creating instruments that are not truly fungible would introduce instability and make pricing difficult. Various proposals are being investigated to see how these systems might be linked across markets, with the International Carbon Action Partnership (ICAP) as an international body to help co-ordinate this.[50][51]

With the creation of a market for mandatory trading of carbon dioxide emissions within the Kyoto Protocol, the London financial marketplace has established itself as the center of the carbon finance market, and is expected to have grown into a market valued at $60 billion in 2007.[52] The voluntary offset market, by comparison, is projected to grow to about $4bn by 2010.[53]

23 multinational corporations came together in the G8 Climate Change Roundtable, a business group formed at the January 2005 World Economic Forum. The group included Ford, Toyota, British Airways, BP and Unilever. On June 9, 2005 the Group published a statement stating that there was a need to act on climate change and stressing the importance of market-based solutions. It called on governments to establish "clear, transparent, and consistent price signals" through "creation of a long-term policy framework" that would include all major producers of හරිතාගාර වායු.[54] By December 2007 this had grown to encompass 150 global businesses.[55]

Business in the UK have come out strongly in support of emissions trading as a key tool to mitigate climate change, supported by NGOs.[56] However, not all businesses favor a trading approach. On December 11, 2008, Rex Tillerson, the CEO of Exxonmobil, said a carbon tax is "a more direct, more transparent and more effective approach" than a cap and trade program, which he said, "inevitably introduces unnecessary cost and complexity." He also said that he hoped that the revenues from a carbon tax would be used to lower other taxes so as to be revenue neutral. [57]

Meaningful emission reductions within a trading system can only occur if they can be measured at the level of operator or installation and reported to a regulator. For හරිතාගාර වායු all trading countries maintain an inventory of emissions at national and installation level; in addition, the trading groups within North America maintain inventories at the state level through The Climate Registry. For trading between regions these inventories must be consistent, with equivalent units and measurement techniques.

In some industrial processes emissions can be physically measured by inserting sensors and flowmeters in chimneys and stacks, but many types of activity rely on theoretical calculations for measurement. Depending on local legislation, these measurements may require additional checks and verification by government or third party auditors, prior or post submission to the local regulator.

Another critical part is enforcement.[58] Without effective MRV and enforcement the value of allowances are diminished. Enforcement can be done using several means, including fines or sanctioning those that have exceeded their allowances. Concerns include the cost of MRV and enforcement and the risk that facilities may be tempted to mislead rather than make real reductions or make up their shortfall by purchasing allowances or offsets from another entity. The net effect of a corrupt reporting system or poorly managed or financed regulator may be a discount on emission costs, and a (hidden) increase in actual emissions.

There are critics of the methods, mainly environmental justice nongovernmental organizations (NGOs) and movements, who see carbon trading as a proliferation of the free market into public spaces and environmental policy-making.[59] They level accusations of failures in accounting, dubious science and the destructive impacts of projects upon local peoples and environments as reasons why trading pollution allowances should be avoided.[60] In its place they advocate making reductions at the source of pollution and energy policies that are justice-based and community-driven.[61] Most of the criticisms have been focused on the carbon market created through investment in Kyoto Mechanisms. Criticism of 'cap and trade' emissions trading has generally been more limited to lack of credibility in the first phase of the EU ETS.

Critics argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Overall reductions would need to come from a sufficient and challenging reduction of allowances available in the system.

Regulatory agencies run the risk of issuing too many emission credits, diluting the effectiveness of regulation, and practically removing the cap. In this case, instead of any net reduction in carbon dioxide emissions, beneficiaries of emissions trading simply do more of the polluting activity. The National Allocation Plans by member governments of the European Union Emission Trading Scheme were criticised for this when it became apparent that actual emissions would be less than the government-issued carbon allowances at the end of Phase I of the scheme.

They have also been criticised for the practice of grandfathering, where polluters are given free allowances by governments, instead of being made to pay for them.[62] Critics instead advocate for auctioning the credits. The proceeds could be used for research and development of sustainable technology.[63]

Critics of carbon trading, such as Carbon Trade Watch, argue that it places disproportionate emphasis on individual lifestyles and carbon footprints, distracting attention from the wider, systemic changes and collective political action that needs to be taken to tackle climate change.[59] Groups such as the Corner House (organisation) have argued that the market will choose the easiest means to save a given quantity of carbon in the short term, which may be different to the pathway required to obtain sustained and sizable reductions over a longer period, and so a market led approach is likely to reinforce technological lock-in. For instance small cuts may often be achieved cheaply through investment in making a technology more efficient, where larger cuts would require scrapping the technology and using a different one. They also argue that emissions trading is undermining alternative approaches to pollution control with which it does not combine well, and so the overall effect it is having is to actually stall significant change to less polluting technologies.

The problem of unstable prices can be resolved, to some degree, by the creation of forward markets in caps. Nevertheless, it is easier to make a tax predictable than the price of a cap. However, the corresponding uncertainty under a tax is the level of emissions reductions achieved.

The Financial Times published an article on cap and trade systems which argued that "Carbon markets create a muddle" and "...leave much room for unverifiable manipulation".[64]

More recent criticism of emissions trading regarding implementation is that old growth forests, which have slow carbon absorption rates, are being cleared and replaced with fast-growing vegetation, to the detriment of the local communities.[65]

Recent proposals for alternative schemes that seek to avoid the problems of Cap and Trade schemes include Cap and Share, which was being actively considered by the Irish Parliament in May 2008, and the Sky Trust schemes.

↑Burton, Ellison, and William Sanjour. (1967). An Economic Analysis of the Control of Sulphur Oxides Air Pollution. DHEW Program Analysis Report No. 1967-69. Washington, DC: Ernst and Ernst.

↑Burton, Ellison, and William Sanjour. (1968). A Cost-Effectiveness Study of Particulate and SOx Emission Control in the New York Metropolitan Area. NTIS: PB-227 121/1. Contract Number: PH-86-68-37. Washington, DC: Ernst and Ernst.

↑Burton, Ellison, and William Sanjour. (1969). A Cost-Effectiveness Study of Air Pollution Abatement in the Greater Kansas City Area. NTIS: PB-227 116/1. Washington, DC: Ernst and Ernst.

↑Burton, Ellison, and William Sanjour. (1969). A Cost-effectiveness Study of Air Pollution Abatement in the National Capital Area. NAPCA Contract No. PH 86-68-37, NTIS: PB227110. Washington, DC: Ernst and Ernst.